What Is Depreciation?
Long-term assets like computers, machinery, and other business equipment can be written off on your taxes via depreciation. But when should you depreciate an asset rather than expense it on your taxes?
Tax season is stressful as is. Throw in confusing terms like depreciation and it’s enough to make someone run in the other direction. Luckily, depreciation sounds a lot scarier than it is.
Depreciation is simply a way for businesses to write off certain purchases and assets. We’ll explain exactly what depreciation is, how it works, and when to use depreciation over standard deductions in this complete tax guide.
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What Is Depreciation?
Depreciation is a method of writing off an expense over a period of years rather than all at once with a typical tax deduction. Depreciation is used for purchases and expenses that are considered long-term assets, meaning their usefulness lasts longer than one year.
For example, a computer is a long-term asset because it is useful for multiple years, whereas a purchase like computer paper is a short-term asset because it will be used up within one year. In tax season, a business could use depreciation to write off the computer and a standard deduction to write off the computer paper.
By writing off an asset over time, businesses get a tax break for each year of the asset’s useful life, until the asset hits its salvage value (salvage value is the remaining value of an asset after it has reached its useful life).
Common Assets That Can Be Depreciated
Depreciation only applies to tangible assets with a useful life of more than one year. Here are several examples of common depreciable assets:
- Office furniture
- Property buildings
- Property improvements
When To Expense VS Depreciate An Asset
Depreciation is a method of deduction, but when do you use depreciation over a one-time deduction?
Businesses should depreciate a purchase if the asset’s useful life is greater than one year. By contrast, you must “expense” a purchase, or take a one-time write-off, if the asset will be used up within one year.
Businesses should also consider depreciation if they own property. Property can be deducted through a process called cost segregation and can shorten the traditional 27.5-year or 39-year lifespan periods of real estate to 5, 7, or 15 years, resulting in serious tax savings. Learn more about how cost segregation works or connect with a cost segregation company directly to see if you qualify for this deduction.
How Does Depreciation Work?
There are multiple methods and formulas used to calculate depreciation. The IRS also has very specific depreciation rules, percentages, and limits depending on the type of expense being depreciated.
For example, not every depreciable asset is a 100% deduction; some have limitations and businesses can only write off a certain percentage outlined by the IRS.
We’ll cover the basics about the different types of depreciation to get you started, but the best way to understand the detailed ins and outs of how depreciation works for each of your business’s assets is to talk with your accountant.
Types Of Depreciation
There are four to five depreciation methods (some accountants count declining balance depreciation and double-declining balance depreciation as one method, while others count it as two separate methods).
All depreciation methods require the asset’s salvage value. Salvage value is the amount an asset is worth at the end of its life and uses this formula:
Salvage Value = Purchase Cost – (Depreciation Percentage x Total Years of Useful Life)
Once you know the savage value of your asset, you can use one of the five depreciation methods to depreciate your expense — or, if you’re content enough with the general knowledge of how expenses are depreciated and would rather leave the nitty gritty details to your accountant, we don’t blame you! Scroll on to read for more depreciation basics business owners should know.
What Is Bonus Depreciation?
Bonus depreciation lets businesses claim an extra bonus allowance during the first year a depreciable asset is purchased. Bonus depreciation is typically allowed for property purchases (it’s worth noting that while property buildings are depreciable, land isn’t because land doesn’t lose value over time).
What Is Accumulated Depreciation?
Accumulated depreciation is the total amount of depreciation that an asset has accrued so far in its useful life since the asset was originally purchased.
What Is Recoverable Depreciation?
Recoverable deprecation is the difference between an asset’s actual cash value (ACV) and the cost of replacing that asset.
The term recoverable depreciation is heard most often when it comes to property insurance or homeowner’s insurance.
Is Depreciation Different Than Amortization?
Depreciation and amortization are two different processes used to write off assets. The difference is that depreciation is for deducting tangible assets over a period of multiple years, whereas amortization is a means of deducting intangible assets over a period of years.
How To Calculate Depreciation
To calculate deprecation you’ll need to know the purchase cost of the depreciable asset, the salvage value of that asset, the depreciation method you want to use, and the calculation formula for your selected deprecation method. Each method is calculated slightly differently to get your yearly depreciable amount.
You’ll also need to carefully understand the IRS’s rules and regulations regarding your specific depreciable asset. Sounds complex right?
The actual depreciation formulas are fairly simple, but the ins and outs of choosing between depreciation methods and understanding the IRS’s detailed tax codes are not. Depreciation is not for the faint of heart.
While it’s important for business owners to understand the basic principles of depreciation, we highly recommend you leave the actual depreciation calculations to a professional accountant or tax preparer. This will save you time and give you serious peace of mind that your deprecation calculations are correct– and that your business is getting the best tax return possible this tax season.